Thursday, March 12, 2009

Inflation as Loss Function

Banks create money and then lend it to borrowers. The quality of projects that banks select will cause inflation, stable prices or deflation. The best quality projects would cause productivity to exceed the amount of money created, and so monetary expansion to be deflationary. If projects that banks select just equal the average quality of economic productivity then there will be neither deflation nor inflation. If banks consistently choose projects that are inferior to the average project with respect to productivity then there will be inflation.

This suggests that inflation can be viewed as a quality loss function (see discussion in Taguchi). The target loss should be negative. Economically, diminishing marginal productivity suggests that as more money is created losses will be greater. However, if banks are competently run and have adequate quality processes with respect to project selection, they can offer loans to projects and sustain zero inflation.

The management of banks becomes a critical problem to economic welfare if the banks themselves lack quality management capacity to select loans. This has been the case. It is impossible for outsiders to design quality processes that will improve loan selection because this depends on identification of borrower and project characteristics that are only known to lenders.

There is no literature on selection of entrepreneurial risk by lenders. This is not a topic that academics have treated and it is not a topic that bankers have carefully considered.

As a result of the absence of quality processes in making loans, the financial system has failed to make loans effectively. The current financial process results from quality losses, i.e., the Taguchi loss function among banks is large and so results in bad loans. Consistent inflation since the establishment of the Fed suggests that banks have failed to develop competent quality processes in lending.

Anecdotal evidence suggests that banks have consistently made loans based on incompetent criteria: to large institutions who cannot make good use of the funds; to firms with close connections to the banks and to firms engage in activities that loans other banks are making. This mimetic pattern suggests a financial system that is, in Deming's terms, "out of control". A competently run banking system would permit economic expansion coupled with stable prices.

The banking system requires restructuring to facilitate adoption of competent, quality driven practices with respect to lending. Banks must become competitive. Banks which fail to produce loans that generate net gains to society (i.e., deflationary loans) should be refused access to Federal Reserve bank credit.

4 comments:

I don't think so. It will only make matters worse because the state will have every incentive to monetize its debt. This was done in the US under the first and second banks of the United States, which were partially (20%) owned by the US government. The result was the same kind of corruption and speculation as exists under the Fed. Nationalizing an inherently corrupt institution will not change its essential corruption. The nation did best from 1836 to 1913, when there was no central bank. Millions of immigrants flocked here and real wages rose consistently. There was more innovation than during any other period in US history.

Sweden is fine if your idea of a dynamic economy is a smorgasbord and a SAAB story.

The problem with nationalization is that it leads to suppression of freedom. The reason is that as public sector control extends to greater areas of the economy, critics of the state find it ever more difficult to gain employment because of "political correctness". In a country like Sweden there is relatively little diversity. It is not particularly innovative or creative. It is not a leader. Moreover, it is very small, smaller than a single US state, its population is 9 or 10 million.

Despite extensive welfare services, its tax rate is hardly higher than in the US. The tax rate is above 50%, but the US approximates this. The payroll tax in the US is lower than in Sweden, but real estate, sales and state taxes push the US tax rate fairly close to Sweden's. Nevertheless, US taxpayers receive scant services in contrast to major welfare and health services provided in Sweden.

Now, let's extend the US government's power so that taxes exceed those of Sweden (which would happen in part due to inflation). I wonder how much better off Americans would be? I wonder whether the extra resources diverted into government coffers would go into the pockets of Pickpocket Barack's cabinet of crooks (his treasury secretary is actually a tax cheat! The chutzpah and stupidity!) and how much would subsidize the average American?

An interesting theory but does it not assume that money supply remains constant? Surely, inflation is more to do with bad money which the Fed is able to inflate of which low interst rates are a consequence. It is these low interest rates that cause malinvestment.

Hey GmT. I'm assuming inflation. My idea is that the Fed creates money, deposits with banks who then lend. The mercantilist theory is that the new projects the loans fund will produce more value for the economy than the new money will depreciate the currency. The result will be reduced prices, deflation. Inflation occurs only if this idea fails, i.e., there are quality losses due to bad loans. No economist can identify which loans are good, and there is absolutely nothing in economics to suggest how lenders can identify productive loans. True, they can identify borrowers who are good credit risks and more likely to repay, but that's beside the point.

Say the Fed inflates by 1% and the banks expand the money supply by 3%. Then the new projects that are funded by the 3% must increase overall national productivity by 3% to be non-inflationary. If they expand national productivity by less than 3%, then they are inflationary.

Economists assume on faith that bankers are able to sort through the potential borrowers to find the best risks. That's why they created the recent banking meltdown. American banks are to banking quality as American auto companies are to automobile quality.

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Mitchell Langbert

About Me

I have researched and written about employee benefit issues and in my previous life was a corporate benefits administrator. I am currently associate professor of business at Brooklyn College. I hold a Ph.D. from the Columbia University Graduate School of Business, an MBA from UCLA and an AB from Sarah Lawrence College. I am working on a project involving public policy. I blog on academic and political topics.